Looking for a way to save money for retirement outside of your 401(k) or other employer retirement plan? An IRA may be the right choice for you. IRA stands for individual retirement account. They’re designed to help individuals save for retirement, and they offer several tax benefits to make long-term saving easier and more appealing.
While there are several different types of IRAs, two of the most popular are the traditional IRA and the Roth. Both allow you to contribute up to $5,500 per year, although you can contribute an additional $1,000 per year if you are over the age of 50.1
If you’re considering an IRA, which one should you choose? While traditional IRAs and Roth IRAs can both be excellent retirement income saving vehicles, there are distinct differences between the two. Here are a few factors to consider as you explore your options:
Both the traditional IRA and the Roth IRA offer tax benefits, but they differ slightly between the two. With a traditional IRA, you get a deduction for your contribution amount in the year you make the contribution. That is, of course, assuming you fall within the IRS income thresholds for traditional IRA deductions.
In a traditional IRA, your investments also grow tax-deferred. That means you do not pay any taxes on your earnings until you withdraw money from the IRA. At that time, all withdrawals are taxed as ordinary income.
In a Roth IRA, you don’t get a tax deduction for contributions. However, you also don’t pay taxes when you withdraw money, assuming you are over age 59 ½ at the time of the withdrawal. That means you can deposit money today, grow it until retirement and then withdraw the money tax-free.
Traditional and Roth IRAs also differ in terms of how early withdrawals are treated. In both cases, the eligible withdrawal age is 59 ½. If you withdraw money before that age you could face taxes or penalties, but those taxes and penalties will be based on which IRA you have chosen.
In a traditional IRA, an early withdrawal often results in taxes on the withdrawal plus a 10 percent penalty. In some instances, the penalty may be waived. For example, you can receive a penalty exception if the early withdrawal is needed because of disability, a first-time home purchase or a variety of other reasons.
In a Roth IRA, the rules for early withdrawals are a bit more lenient. You can always withdraw your contributions tax-free, and penalty-free, at any time. However, you could face income taxes and the 10 percent penalty if you withdrawal earnings from your account. Like traditional IRAs, you may apply for a penalty exception if you feel you meet the criteria.
Required Minimum Distributions
A traditional IRA requires you to start withdrawing money from your IRA at age 70 ½. These withdrawals are called required minimum distributions, or RMDs. The amount you must withdraw varies each year based on your account balance and your age. Generally, you can expect the minimum amount you are required to withdraw to increase with age.
The reason for RMDs is simple. The distributions from traditional IRAs are taxable. The IRS wants to collect that tax at some point while you are alive. Hence the requirement to start taking taxable income when you reach a certain age.
In Roth IRAs, there are no RMDs. You can defer withdrawals as long as you like. Or, you can never take a withdrawal at all. The choice is up to you.
Both traditional and Roth IRAs can be effective saving tools. There’s no universal answer as to which one is best. The answer to that question depends on your own unique goals, needs and concerns.
Consult with your financial professional. They can help you decide which type of IRA is right for you.
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